More on margin of safety

A frequently asked question on value investing is this: how can you be so sure that the co's intrinsic value is $100 (or any other no.)?

For those not so sure what the hell is going on, read these first
Value Investing
Intrinsic Value
Good Investment

Well, the truth is, you are never sure, you can spend 20 days calculating the intrinsic value of the company and become so sure that the stock is undervalued. So you buy and the stock tank 20%. Shiok huh?

Intrinsic value goes hand in hand with margin of safety. Bcos you can never be sure whether you really got the intrinsic value right, you need to have a margin of safety. ie you will only buy the stock if the current price is way, way, WAY below your calculated intrinsic value. As a rule of thumb, I recommend 30-40% below your calculated intrinsic value. That is if you calculated that a stock is worth $100, you should be buying only when it hits $60-70.

Buffett used the example of building a bridge. If you know that the maximum weight of vehicles that will cross the bridge is 10 tons (based on historical statistics), will you build a bridge that will support 10 tons or a bridge that will support 30 tons?

That is margin of safety.

Ben Graham, the grandfather of value investing once said this: if you need to surmise value investing into only 3 words, it would be "margin of safety". It is THAT important.

Unfortunately, most investors don't really have this concept in mind. Even those who are very experienced. I guess it's not easy partly bcos have a strict margin of safety rule forces you to pass on many investment ideas even if they are quite good. And when you see them rally 100% after you decided NOT to buy them, wah shiok right? Now every wall you see has a purpose. For you to bang your head hard on it! Haha!

But having a margin of safety will make very sure that you will not lose your shirt. Even if you are damn wrong on your intrinsic value, you may lose a bit of money, the stock may tank 20%, below your buying price but quite unlikely to tank 80% below your buying price. And chances are after it tanked it will creep back up again, it will not bankrupt you. That's the strength if you have a huge margin of safety.

Getting Whipsawed!

Whipsaw is a wonderful description of a trade. Specifically you buy some stock, it goes down 20% and you sold out, intending to preserve whatever capital you have left. And the next thing you know, the stock goes up 100%! Shiok right!

Actually the fear of getting whipsawed is so great that it causes a lot of investors to make silly mistakes. But if you think about it, even if you really get whipsawed, it's not a big deal except for the psychological factor. Say you cut loss at 10% and the stock subsequently rallied, so you would have lost just 10%. But if you did not cut loss and stock continues to decline, you will eventually lose maybe 50-60%.

Let's for argument sake, make the example a bit more mathematical. Say you bought a stock at $10 and it plunges to $8. There is a 50% chance that it may rebound 50% to $12 and 50% chance that it plunges another 50% to $4.

So you have two choices now:

Choice 1: If you cut loss, you lose $2

Choice 2: You wait out the storm,
If you get lucky, you make $2, as the stock rise back to $12
If you are damn suay and the stock continue to plunge to $4, you lose $6

Let's assume it's 50:50 between the $2 and -$6, your expected return of not cutting loss is $-2 (0.5*2+0.5*-6), which doesn't make you better off than if you had cut loss. Actually it's probably 70-80% chance that it will go down. Logically thinking stock at $10 which had gone down to $8 should continue to decline bcos something had gone wrong in the first place. So unless a new positive catalyst appears, the stock will not rally.

However the fear of getting whipsawed is so great that it blurs the rational mind. If the stock did rebound and go back to $12, most pple would rather kill themselves than to admit that they only lost $2. This fear of getting whipsawed makes us hold on to our losses longer than we should.

Gambler's Ruin Takeaways

Well actually, Gambler's Ruin has more to do with speculating than investing. Nevertheless I think we can learn a few things from Gambler's Ruin.

Btw Kelly's Formula is

% of money = odds of winning - (odds of losing / payout)

Eg. You think Stock A that have a 60% chance of going up 80%
Then % of money = 0.6 - (0.4 / 0.8) = 0.1

ie you should be putting at most 10% of your money in this stock
But take note that ALL the inputs are arbitrary, the odds, the payout.
The formula output is only as good as the inputs.

Ok here are the takeaways:

1. If you simply buy a fixed dollar amt, like $1,000 for every stock you will go broke as time passes, even if the odds are fair. And you will go broke even faster, esp if the odds are against you. (As far as investing is concerned, in most cases, the odds ARE against you).

2. Even if the odds are in your favour, betting the same absolute amt doesn't make sense, you need to apply Kelly's Formula or its variations to optimize returns. This means that you should always decide how much money to invest based on a % of your total amt of money and not an absolute amt. And this % should be decided by the Kelly's Formula or some modifications (half Kelly etc) of it.

3. Building on the previous point, one of the most popular implementation is actually the much talked about rebalancing method used by institutions and shrewd indvidual investors. Say you have 60% in stocks, 30% bonds and 10% cash. You should rebalance your portfolio whenever the ratios are out of whack. Like maybe stocks go up to 70% during boom time, so bring it down back to 60%. This makes sure you buy low and sell high and at the same time mitigate Gambler's Ruin.

Ben Graham, father of value investing, advocates always maintaining a ratio of 50:50 in stocks and bonds (with possible digression to 25:75 or 75:25). In the same line of thought, when the ratios are out, say stocks go from 50% to 80%, then you should bring it back down by selling. This ensures that you buy when it is low and sell when it is high.

Gambler's Ruin

Here is a tip for this Chinese New Year gambling.

The concept of Gambler's Ruin was mentioned in a very insightful book called Fortune's Formula which I thought deserve more scruntiny, both from gambling and investing point of view.

The story goes as follows. Imagine you have some money and you decide to bet a fixed amount in a game where your probability of winning is 50%. Say you have $100, you want to bet $1 on "Big" and "Small" (and in this case, there is no "House Win" like double sixes. Bcos if there is "House Win", your winning probability would be less than 50% which we do not want in this story yet).

So what is the probability that you will lose all your money after some time?

Well it's 100%!

This is intuitively illogical bcos the odds are 50% right? Why should one lose everything? Well the caveat here is "after some time" which is as good as saying "playing forever". If you play forever, you are bound to lose everything, which can be shown mathematically and that's what we are gonna do in this post. If you decide to stop after winning a certain amt of money, then good for you, it's possible that you achieve your goal and leave the casino with some money.

The mathematical proof of why you can expect to lose everything if you play for a long time (or rather forever) goes as follows:

The probability of either losing your money or doubling your money is 0.5. Consider these mutually exclusive cases:

Case 1: Probability of losing all your money after X1 no. of bets = 0.5
Case 2: After X1 no. of bets, you have doubled your money (0.5), but you continue to play for another X2 bets, so probability of later losing everything again = 0.5*0.5 = 0.25
Case 3: After X1 + X2 no. of bets, you double your money yet again, lucky you! (0.5*0.5), but you continue to play another X3 bets, and the probability of later losing everything = 0.5*0.5*0.5 = 0.125

The no. of cases go on and you add up all the probability that you will go broke = 0.5+0.25+0.125+... = 1

So, as long as you bet the same absolute amt, even in an even odds game, you WILL lose everything in the end.

This link allows you to simulate exactly what will happen and I tried it and recorded down that it takes about 20,000 games to go broke if you have $100 and the odds are 50% (which is quite a lot, but still the math is against you). If the house odds just goes up by 5% (ie your probability of winning is 45%), you lose everything in less than 1,000 games.

So what to do? Well the book says that you should follow this formula called Kelly's Formula to decide how much to bet (which is a % of your money rather than a fixed absolute amount). In this case, the formula actually says don't bet though...

So don't keep betting $1 during the usual CNY Big/Small game. Vary your bet size according to Kelly's Formula!

Random Thoughts on Various Investment Topics

In this post I would like to share my thoughts on my stance on various matters in investing like whether EMH works or not, TA is bullshit or not etc. So let's start!

Value concepts: I subscribe to most value investing concepts like margin of safety, circle of competence, buy things on sale, value-for-money etc. Most of these are very common-sensical and I don't think there is a need to argue with that. If you have no idea what are these, start reading this blog from the first post back in early 2006.

EMH is bullshit: One thing that I do not agree with other value investors would perhaps be the lack of respect for efficient markets. I think that markets are efficient and it's not easy to beat them. The market is the confluence of everybody's viewpoints and this collective wisdom is actually, usually right, at that point in time. However the market also has an investment horizon that is the average of its participants' horizon, which is usually not very long, abt 1 yr I think. This is probably the only reason why value investors get to have an edge, bcos we look at co.s with solid fundamentals that should outlast market's short-termism over time. Still, I don't think it's easy to get much higher than average return of 8%pa.

Chart reading: I used to think that chart reading is pretty much bullshit bcos if you look at past tosses of coins, can you use that to predict the outcome of your next toss? No. But that is what TA is trying to do. However, prices are not like coins and do have some memory so it might predict future prices. But my guess is its predictive power is probably 2-3 days. So, not that useful. The reason why TA can still work is probably self-fulfilling prophecy at work. Lots of participants playing the game with TA and hence prices do bounce off support levels. I did a simple simulation on the comment section of the last post. Basically, it's possible to make positive return using TA but again, you may not beat market returns. Nonetheless, there are pple who can beat the market using TA and I salute them.

Trading rules: I think this is a useful tool but it works only if you fit it to your temperment, style and investment horizon. E.g. cut loss at -10%. Some can be religious and do it everytime. Some cannot, and see -10% become -50% and curse and swear. According to the value doctrine, you should buy MORE when it drops bcos it just got cheaper right? Well it can go even cheaper, like 2008 and 2009 or even 2010. And your initial analysis must be right. ie things have not changed. If things have changed, the stock is no longer at the original intrinsic value that you calculated, then really must cut. Take profit rule sucks I think. If you sell anything with a 20-30% profit, how are you ever going to make the big buck?

Diversification: Again, this is probably where I differ from the guru (ie Buffett). I think this makes a lot of sense. Diversification is said to be the only free lunch in investing. Of course one major shortcoming is that you must have enough capital. Some textbook says around 30 different investments and they must be relatively uncorrelated lah. This is hard, bcos in today's world, everything just follows everything else. Nevertheless, don't put all your eggs in one basket. Yes we have limited time, money etc. You research on this stock so much and buy 1 lot and see it go up 200%. WTF right? But which is more painful, entire savings become zero or missing out 200%? Beware of the Black Swan!

Well, as most would have realized, I don't subscribe to everything on the value investing doctrine. But I think the core of successful investing has to be Graham/Buffett value philosophy. And now is the time to take action as the fire sale is going on!

Free Cash Flow and Dividend Stocks

As we enter the new year, this is the bonus post that hopefully can make us rich in time to come!

Short Name Industry Subgroup Dividend Yield
SINGAP SHIPPING Transport-Marine 10.53
SIA ENGINEERING Commercial Services 10.05
MOBILEONE LTD Cellular Telecom 9.864
SINGAP AIRPORT T Airport Develop/Maint 9.859
DEL MONTE PAC LT Food-Canned 9.586
SINGAP REINSURAN Reinsurance 9.154
SINGAP PRESS HGS Publishing-Newspapers 8.599
CEREBOS PACIFIC Food-Misc/Diversified 8.503
SINGAPORE POST Transport-Services 8.17
SINGAPORE FOOD Food-Misc/Diversified 7.684
SINGAPORE EXCH Finance-Other Services 7.49
HAW PAR CORP Diversified Operations 6.964
SINGAPURA FINANC Finance-Mtge Loan/Banker 6.667
UNITED O/S INSUR Property/Casualty Ins 6.55
HONG LEONG FINAN Finance-Other Services 6.341
PARKWAY HLDGS Medical-Hospitals 5.804
GREAT EAST HOLD Life/Health Insurance 5.791
SING INV FIN Diversified Finan Serv 5.714
CHUAN HUP HLDGS Transport-Marine 5.263
UNITED OVERSEAS Commer Banks Non-US 5.208
RAFFLES EDUCATIO Schools 5.13
APB BREWERIES Brewery 3.168

This is a list of stocks that have never had a single year of negative free cash flow for the past 8 years and hence I would deem that they should be able to pay dividends for the foreseeable future.

As a surprise, high dividend yield is not selected as a criteria for this list but 15 out of 23 stocks have a dividend yield of more than 6% which I think as high considering that with their strong FCF generative ability, the co.s have less probability of cutting their dividends and what you see is likely to be what you can get as dividends. But don’t be too hopeful, co. mgmt can play the conservative card and decide to keep cash and not pay you.

Incidentally, out of the 700 stocks listed on SGX, only 30 stocks had never had a year of negative FCF and in my opinion, these should be part of the truly investable stocks on SGX.

This drives another point that I have made before. Most stocks on SGX are crap and it is not worth spending time investigating and investing in them.

This does not mean that this list represents ALL the investable stocks on SGX. Or that stocks that don’t make it to this list equals crap. Certainly not! It also does not mean that every stock on this list will turn out to be 5-10 baggers in the future. If this happens, I would require a 25% share of your future profits. But probably, I should have made so much money that I wouldn’t be blogging here. Right?

The list is generated with no regard to the qualitative aspect of the various co.s, like mgmt capabilities, co’s past actions, true source of their cashflow, shareholder friendliness etc. I would advise you to do a lot more work on each of these co.s if you are seriously thinking of putting money into them. Names that I would avoid now would be Parkway: seems like that they might run into cashflow problems with their huge expansions. Others would be Singapura Finance, Raffles Education. Singapura Finance: totally don't know what they do. Raffles Education: wary of what they are doing...

It is unlikely that 80% or even 60% of the stocks on this list will turn out to be spectacular investments. Looking at the 10 year performance to date for this list of stocks, a handful of them have actually declined 50% in the past 10 yrs, making them serious lemons!

Well, that’s investing. Something like finding your life partner. You never get 100% of what you want: e.g. no chores, no quarrels, honeymoon every day, guy’s nights out with no curfew, no anniversary Carat upgrade request but Omega watch present every year, yeah dream on... Hopefully, we get some of what we want, and live with some of what we don't want. And things don't turn out too bad.

My hope would be that this list gives similar results.

Enterprise Value and Free Cash Flow II

This is a continuation of the last post talking about EV and FCF.

A company generates cashflow based on its day-to-day operations. Eg. SIA selling air tickets with fuel surcharges 2x actual ticket prices. The millions of ticket sales generate cash. Of course SIA needs to pay the pilots, the stewardesses, the fuel, landing charges etc. After netting the expenses, it should still have cash left. Some co.s don't, if you own some of these, good luck! Anyways, this no. is called Cashflow from Operations.

Next, SIA needs to spend some of this cashflow on equipment to maintain its operations. Like buying new planes, pilot training programs, etc. This no. is called Capex which is the short-form for capital expenditure.

When you deduct Capex from Cashflow from Operations, you get a no. called the Free Cash Flow. Basically, that's what's left that can be distributed to shareholders or to pay down debt. If the company has no debt, it's basically money that can be paid to the shareholders.

Over the course of many many years (like 10 yrs or more), a good co. will generate significant Free Cash Flow and has the capacity to even grow this amt over time. Now finally, things are getting interesting right? These are co.s that value investors look out for. Usually, I would look at that past 10-15yrs of FCF and take an average amt to use that to calculate EV/FCF. I am assuming that the company can generate this average FCF in the future for many many years.

Let's look at SIA. Over the past 10 years, SIA has 5 yrs of positive FCF and 5 yrs of negative FCF. Cumulatively, it generated a miserable S$175mn of FCF. Our ministers' salaries over 10 years would have generated as much. This is what the most profitable airline in the world can manage. Moral of the story: Don't ever buy an airline!

Combining the two things, you get EV/FCF which is just a measure of the cheapness of the company. The lower the better, like the PE ratio. If this ratio gives 5x, it means that theoretically, you get back your money in 5 yrs. Usually it doesn't get cheaper than that. EV/FCF ranges from 5-15x usually.

Again, back to SIA, the EV is S$8.8bn based on current stock price of S$11+. Calculating EV/FCF give 8800/175 = 50.3x. If you buy SIA today, the free cashflow generated should be able to cover your purchase in about 50 yrs. That's great isn't it? Maybe just in time to cash out and pay for the funeral expenses!

Enterprise Value and Free Cash Flow I

Once upon a time, we talked about a radical ratio called EV/EBITDA which was invented and nearly won the Nobel Prize in Most Innovative Financial Ratio ever invented. Well someone topped that and invented EV/FCF which is Enterprise Value over Free Cash Flow.

What's so great about EV and its alphapetical soup of acroynms? Ok, let's define the terms first.

EV = Market cap + Net Interest bearing debt
FCF = Cashflow from Operations - Capex

For the uninitiated, pls follow the hyperlinks and read what is Market Cap, Cashflow from Operations etc. I will explain EV and FCF.

EV stands for Elise Vuitton, cousin of Louis Vuitton who recently came out with her own luxury brand of leather bags to grab share from the legendary LV.

Oops, wrong number. Ok, here's the real deal.

EV is sort of the theoretical takeover price of a company. In the event of a buyout, an acquirer would need to pay the market price (or market cap) to the existing shareholders. However he would also have to take on the company's debt, but pocket its cash (hence looking at NET interest bearing debt is impt). If a company has no debt and some cash, then EV is less than market cap and the acquirer will be getting a bargain!

Actually in today's market, some co.s are trading below net cash! This means that EV is actually negative. You get paid to buyout some co.s listed on SGX! It goes to show how irrational things can get when markets go crazy. However, as quoted by the great Keynes: markets can stay crazy longer than you can stay liquid. Well usually also longer than you can stay patient lah. Nevertheless, having said all that, it goes to show that markets today are really cheap. This is the Great Singapore Clearance Sale value investors have been waiting for! But wait tomorrow things can get cheaper though.

Anyways, that's EV. In the next post, we shall explore Free Cash Flow or FCF.

Losers' Game

This is the title of an essay and a book by one of the most prominent minds in finance. Just google it to read the original text. I will provide a brief summary here.

In this world, there are two types of games being played. Winners' games and Losers' games. In winner's games, the winner wins through his own actions. In loser's games, the winner wins through his opponents actions. The usual example to illustrate this is tennis. There are actually two type of tennis being played in the world, as observed by some hotshot coach. Amateur tennis and professional tennis.

Professional tennis is a winner's game. Federer wins by delivering the ace that nobody can counter. Or that smash, or whatever. The winner wins through his own actions. In amateur tennis, usually Ah Lian wins by doing nothing. Why? Bcos Ah Beng tries to deliver the ace or that smash to Ah Lian but the ball goes out-of-bounds. Ah Lian wins bcos Ah Beng keeps doing silly things when he is not up to it.

According to the original author: professional golf is also a loser's game. The winner wins by playing it right and let their opponents hit bunker or sand or whatever. But Tiger plays it like a winner's game. Hit bunker but comes back spectacularly and ends with a birdie. That's why everybody loves him!

And finally, the core of this post. What is the biggest losers' game in town? Yes, that's investing. Investing is a loser's game. How do you beat the market?

First, you cannot make silly mistakes. In all loser's games this is the first criteria. You cannot try to be like Federer. Play it safe. do the boring parry. In investing it means don't buy on rumour, don't try to do that punt bcos it dropped 50% in one week, next Monday sure rebound one! Or die die do 2 trades every month to meet that stupid broker quota to save a few dollars on overseas stock deposited at the broker. These are like Ah Beng trying to be Federer. Well unless you ARE like Federer, ie you can trade damn well and earn these quick bucks with 99% success rate, like legendary traders Baruch, Livermore. If so, then ermmm why are you reading this post, you should already be a Big Swinging Dick trading big bucks and writing your own blog! Well, I'm flattered anyways.

Second, you only beat the market when it makes mistakes. Alas, the market don't make mistakes. The market is always right, remember? Well the market is right until the time horizon where all the participants can see what's going on. E.g. the market fell 50% this year as all the participants can only see the severe recession coming in 2009. Nobody knows what's gonna happen after that. If we don't go into the 1930 Great Depression scenario, global economy will bounce back in 2010, 2011, 2012, who knows. But when it does, solid co.s like Coca Cola, Canon, LVMH will continue to grow. So that's one way to beat the market. Sometimes, the market does some obvious mistakes. Like mkt cap of Citigroup going lower than the combined mkt cap of Sg 3 banks. Unless C is going under, this should not happen. And after Lehman went down and create this mess, will the authorities let Citi go down? So in such rare occasion, you can beat the market. But by and large, market don't give you that many chances.

So the conclusion: don't trade, play it safe, and according to the author, who is a strong supporter of indexing, buy indices. Buy the STI ETF, or the S&P500 or the Hang Seng. It's futile to beat the market, so just earn market return.

Fallacy of scruntinizing ratios for the past few years

Financial statements are very essential in fundamental analysis and value investing. To value investors, it's like soldier's M16, accountant's Excel, taxi driver's taxi, you get the idea. From the statements, we calculate the all important ratios. Basically it's one number divided by another and that's supposed to give you insights into the company's business operations, its edge or whatever. Something like adding apple juice to aloe vera and drinking the new juice will actually make you thin!

Actually around like 2% of the time, looking at ratios actually help a bit. The problem is we always only look at last yr's ratios. Or maybe some diligent analyst will look at ratios for the past 5 yrs. Not bad huh. 5 yrs quite long right? Presidential term only 4yrs. Alas, do they know on average how long is one economic cycle from peak to peak or trough to trough?

Well, its seven years on average. The recent one, 2001 to now and still going. The one before 1997 to 2001. 4 yrs, well sometimes it's shorter than average, obviously. So by looking at 5 yrs of ratios like ROE, operating margin, debt to equity ratio, can you really tell if the co. is really good? Esp if you are looking at 2002-2007 and the ratios just keep improving every yr? Like those we see in annual reports. Sooooo impressive. This co. is really something, we tell ourselves.

Our hero, Warren Buffett some yrs back started to ask co. owners to come forward to him if they intend to sell their stake to Berkshire. One of his criteria: GROWING earnings for the past 15-20 years. So seven years still quite amateur actually. Of course, most Sg co.s were not around 20 years ago. So we just have to make do with seven years lor.

So, that's the moral of the story: a co. with improving ratios for the past few years is not necessary a capable one. Rising tide lifts all boats. Keep the economic cycle in mind when looking at ratios for the past few years.